Loading the player...

What does 'Compound' mean

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other words, compounding refers to generating earnings from previous earnings.

Also known as "compound interest."


Suppose you invest $10,000 into company XYZ. The first year, the shares rises 20%. Your investment is now worth $12,000. Based on good performance, you hold the stock. In Year 2, the shares appreciate another 20%. Therefore, your $12,000 grows to $14,400. Rather than your shares appreciating an additional $2,000 (20%) like they did in the first year, they appreciate an additional $400, because the $2,000 you gained in the first year grew by 20% too. If you extrapolate the process out, the numbers can start to get very big as your previous earnings start to provide returns. In fact, $10,000 invested at 20% annually for 25 years would grow to nearly $1,000,000 (and that's without adding any money to the investment)!

The power of compounding was said to be deemed the eighth wonder of the world - or so the story goes - by Albert Einstein.

How Compounding Works

The formula for calculating compound interest is:

Compound Interest = Total amount of Principal and Interest in future (or Future Value) less Principal amount at present (or Present Value)

                                = [P (1 + i)n] – P

                                = P [(1 + i)n – 1]

(Where P = Principal, i = nominal annual interest rate in percentage terms, and n = number of compounding periods.)

Take a three-year loan of $10,000 at an interest rate of 5% that compounds annually. What would be the amount of interest? In this case, it would be: $10,000 [(1 + 0.05)3] – 1 = $10,000 [1.157625 – 1] = $1,576.25.

When calculating compound interest, the number of compounding periods makes a significant difference. The basic rule is that the higher the number of compounding periods, the greater the amount of compound interest.

If the number of compounding periods is more than once a year, "i" and "n" must be adjusted accordingly. The "i" must be divided by the number of compounding periods per year, and "n" is the number of compounding periods per year times the loan or deposit’s maturity period in years.

Investor.gov, a website operated by the U.S. Securities and Exchange Commission, offers a free online compound interest calculator. The calculator is fairly simple, but it does allow inputs of monthly additional deposits to principal, which is helpful for calculating earnings where additional monthly savings are being deposited.

  1. Compounding

    Compounding is the process in which an asset's earnings, from ...
  2. Continuous Compounding

    Continuous compounding is the process of calculating interest ...
  3. Compound Return

    The compound return is the rate of return that represents the ...
  4. Effective Annual Interest Rate

    The effective annual interest rate is an investment's annual ...
  5. Periodic Interest Rate

    The periodic interest rate is the interest rate charged on a ...
  6. Front Fee

    The option premium paid by an investor upon the initial purchase ...
Related Articles
  1. Investing

    Overcoming Compounding's Dark Side

    Understanding how money is made and lost over time can help you improve your returns.
  2. Investing

    Learn simple and compound interest

    Interest is defined as the cost of borrowing money or the rate paid on a deposit to an investor. Interest can be classified as simple interest or compound interest.
  3. Retirement

    Using Compounding to Boost Retirement Savings

    Allowing growth on your investments to compound over time gives you immense returns when saving for retirement.
  4. Personal Finance

    APR and APY: Why Your Bank Hopes You Can't Tell The Difference

    Do you know the difference between Annual Percentage Rate and Annual Percentage Yield? Check out how they can affect your own account balance.
  5. Retirement

    Compounding Is Important in the Later Years Too

    The power of compounding is even greater in the later years of saving for retirement.
  6. Investing

    Let the Power of Compounding Increase Your Investments

    The power of compounding can exponentially increase the value of your investments over time.
  7. Investing

    How to calculate your investment return

    How much are your investments actually returning? The method of calculation can make a significant difference in your true rate of return.
  1. What is the difference between stated annual return and effective annual return?

    Essentially, the effective annual return accounts for intra-year compounding, and the stated annual return does not. Read Answer >>
  2. How do I use the rule of 72 to calculate continuous compounding?

    Find out why the rule of 72 does not accurately reflect the growth caused by continuous compounding, and which number can ... Read Answer >>
  3. How do I calculate compound interest using Excel?

    Learn how to calculate compound interest using three different techniques in Microsoft Excel. Read Answer >>
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center